Wednesday, October 26, 2011

Sinking in the Euroland of Debt-Sand

It’s common knowledge that when one finds oneself stuck in quicksand and slowly sinking, it is most important to breathe deeply and relax. Frantically struggling to escape the sand in a fear-induced, panicked frenzy will only lead one to sink faster and make the situation that much worse. Well, at least that’s common knowledge for most individuals, but it is evidently very uncommon knowledge for large economies in modern society. Once the brainwashed collective finds itself in a predicament, it will be chaotic struggle until the bitter end. Exhibits A, B, C and D have all been spawned out of Europe lately.

For more than a year now, the European Monetary Union has been caught in wet, sinking debt-sand and has tried to escape by kicking and screaming its way out. First, the “solution” was to force over-indebted nations (Ireland and Greece) into more debt and gut their private economic infrastructure through austerity. When that failed and the contagion spread, they flung even more debt at another debtor nation (Portugal) to see what would stick. After they sunk even further past their hips and towards their chest (Italy and Spain), they began screaming at each other about how best to create more debt and implement more devastating austerity.

That’s where the EMU finds itself now. Almost up to its neck in private, public and derivative debts that are rapidly imploding. Its chest is tightly constricted by austerity, which makes it that much harder to fill its lungs with air and stay afloat, and it only has one metaphorical hand above the surface, hopelessly clawing for salvation. That hand is Germany and, when it gives up, there will not even be the appearance of hope for the Union to survive as it is currently structured. The last two weeks have been ones in which this sheer desperation is on display for the world to see.

It started with an announcement from Merkel and Sarkozy that a “comprehensive” and “sustainable” solution to the European sovereign debt crisis would be reached by the end of October. [The End of the Eurozone]. Essentially, they bet the farm that peripheral EU countries would be kept solvent, the core counties insulated from financial contagion when Greek debt is inevitably restructured and the European banks, with their highly inter-connected, cross-border exposure to bad debts, healthy. It only took a few days before it became clear that Spanish and Italian finances were sinking even faster into the debt-sand.

Merkel was then forced by economic and political reality to radically alter the previous language about a comprehensive solution, warning everyone that the EU Summit concluding on October 23 would bring no “dramatic course-changing events”. [Political Solutions for a Financial Crisis]. Translation: we are still sinking and we are nearly out of breath. The hand of Germany remained clawing, however, and that sad fact apparently provided plenty of fodder for the mainstream financial media to keep some semblance of hope alive in the markets. On Tuesday October 18, The Guardian made the following announcement:

”France and Germany have reached agreement to boost the eurozone's rescue fund to €2tn (£1.75tn) as part of a "comprehensive plan" to resolve the sovereign debt crisis, which this weekend's summit should endorse, EU diplomats said.

The growing confidence that a deal can be struck at this Sunday's crisis summit came amid signs of market pressure on France following the warning by the ratings agency Moody's that it might review the country's coveted AAA rating because of the cost of bailing out its banks and other members of the eurozone.”

The details of this alleged plan are irrelevant, because The Guardian’s report was immediately refuted by Dow Jones, who called it “totally wrong”, and the following day we found out that it was, in fact, totally wrong. France and Germany still could not agree on any of the significant issues, including if to leverage the EFSF, how to leverage the EFSF (Germany and the ECB firmly rejected France’s proposal to turn the EFSF into a bank that could borrow from the ECB), how much to leverage the EFS, and if or how to help shore up capital for Euro-area banks. Soon after, it was clear the weekend Summit was destined to go nowhere fast.

By the night of Thursday October 20, it was announced that there would have to be a “second summit” occurring “no later than Wednesday” before any firm “resolutions” could be made public. Now let’s be clear here. One could be forgiven if all of the above created the impression that, despite the barrage of unfounded rumors, developments in the European crisis response were occurring rapidly and were fluid, but the truth of the matter is that nothing has developed this entire time. The only thing that has happened is that European politicians and officials have publicly admitted they’ve sunken neck deep into the debt-sand and that they are well aware of it.

They are now going to spend the next three days coming to terms with that fact. The Germans, in particular, will be coming to terms with the fact that they cannot keep clawing at the surface forever, because it will not bring them any closer to escaping the debt-sand which threatens the EMU’s existence every single day. Germany’s finance minister has made absolutely clear that it will not approve of any plan to transform the EFSF into a leveraged bank. [1]. Furthermore, the German Budget Committee has stated that it will not allow EFSF guarantees to exceed 211 billion euros, which means it can only provide about one trillion euros (not enough) of insurance if everyone decides to go that route. [2].

It was also made clear that private investors would have to bare much more than 21% of losses on their Greek bond holdings. Perhaps even up to a 60% haircut, which would easily pull the trigger on the sniper rifles that have been training their crosshairs on French banks, and the ratings agencies [hesitantly] that have been training theirs on French sovereign debt, aiming to render France yet another liability for Europe. This for a country whose debt has been steadily increasing for years to reach over 160% of its GDP now. The Financial Times reports on the latest entirely unsurprising development on this front:

“The report also made clear European leaders are considering "haircuts" on Greek bonds far higher than previously known. The study determined that in order to bring a second Greek bail-out back to the €109bn agreed in July, bondholders would have to take a 60 per cent loss on their current holding.

That is significantly more than the 21 per cent haircut agreed in a deal with private investors three months ago. The analysis says that a 50 per cent haircut, increasingly considered the most likely scenario among European policymakers, would put the second Greek bail-out at €114bn, or €5bn more than the July deal. "Recent developments call for a reassessment," the report said. "The situation in Greece has taken a turn for the worse."

Yet another bombshell has dropped on the six-day “marathon” summit by the EU and IMF in a joint report, which essentially stated that Greece could end up devouring the entire 440 billion euros in firepower that the EFSF currently has. If that’s truly the case, then all of the hotly contested debates about whether to leverage the fund to one or even two trillion euros are made irrelevant. Greece’s relatively tiny economy would swallow at least 25% and most likely 50% of the whole fund. The Telegraph’s Bruno Waterfield reports:

”…without a [Greek] default, the Greek debt crisis alone could swallow the eurozone's entire €440 billion bailout fund - leaving nothing to spare to help the affected banks of Italy, Spain or France.

An EU already rocked by divisions between France and Germany over how to increase the "firepower" of the European Financial Stability Facility (EFSF) in order to save the wider eurozone from Greek contagion now faced the prospect of losing it all in one go.”

It gets worse for the sinking Union. The IMF has now told the Europeans that they must impose at least 50% haircuts on Greek bondholders, or else it will not disburse its contribution to the Greek bailout which amounts to a whopping 73 billion euros. That is more than twice the original percentage agreed upon in June, and if investors (Euro banks) don’t play ball and destroy their balance sheets, Greek will technically be in default. Then, there is nothing to stop the EMU from sinking in their debt-sand, the contagion from spreading to Italy and Spain (and maybe France) and the CDS contracts written by American banks from taking them down as well.

First Bloomberg reports on the lack of any idea about what solvency problems the banks are facing and how to deal with them, and then the Telegraph on the IMF condition:

“A 10-hour meeting in Brussels failed to yield a blueprint for banks’ role in a revamped Greek rescue as European finance ministers haggled over what they called a “credible firewall” against fallout from deeper writedowns.

The ministers’ meeting broke up at about 7 p.m. after reaching agreement that European banks may need about 100 billion euros ($139 billion) in capital after marking their sovereign-debt holdings to market values, according to a person familiar with the discussions. This amount is needed to reach a core tier 1 capital level of 9 percent based on a European Banking Authority test, said the person, who declined to be identified because discussions are private.

The struggle to get an accord on bank capital was just one piece of solving the two-year-old financial crisis. Governments also are pushing for deeper writedowns on banks’ holdings of Greek debt, a step the investors are resisting. “

The IMF would no longer be willing to pick up a third of the total bill for rescuing Greece, a contribution worth €73 billion, unless European banks were prepared to write off 50 per cent of Greek debt. "It was grim. The worst mood I have ever seen, a complete mess," said one eurozone finance minister. ”

The Telegraph article then goes to explain just how bitter the mood is between the German Finance Minister Wolfgang Schaeuble, French Finance Minister Francois Baroin and IMF Head Christina Lagarde. The former doesn’t want anything to do with expanding bailouts for anyone at this point, the latter is screaming to everyone that the math just isn’t working and the French minister is begging everyone to help him save French banks from their all but assured demise. Merkel and Sarkozy are floating around there somewhere too, giving each other the “evil eye” when they are not simply shouting at each other to no end.

On top of all that, the European Council President, Herman Van Rompuy, spewed out something about a plan to create a single European Treasury that could override national budgets and unilaterally impose austerity at will, to be located in Frankfurt or Paris. [3]. That may have also been the point where just about everyone else present started throwing tomatoes, or whatever was being served and within reach, at Rompuy's face. Basically, it was a ridiculous suggestion that only served to create even more animosity between all of the countries reluctantly attending the joke of a "Summit" where Germany and France endlessly argue and tick everyone else off.

So while the still clueless US equity investors wait with baited breath for some kind of “comprehensive” announcement on Wednesday, the people allegedly discussing the measures cannot even stand to be around one another anymore. They have been rapidly sinking into the abyss for months now, and who can blame them for not having even an ounce of hope or civility left. They will surely come up with something to say about increasing the “firepower” of the EFSF, creating a “credible” plan for restructuring Greek debt and backstopping Euro banks, but they won’t believe any of it and they won’t expect anyone else to either.

For all the reckless motions of conditioned bailouts, panicked conferences, and incessant shouting, screaming and clawing, the Euroland has simply left itself up to its eyeballs in debt-sand, and that has, in turn, left it with no more hope, comfort or credibility in any meaningful sense of those words. Rumors will keep coming in and going away even faster, but the muted sense of despair and an approaching denouement is what really lurks beneath. It will not be very long before the debt-sand envelops the Euroland’s entire body and leaves only one cold, dead hand as a reminder of what was once a Union sinking, but still alive, if only for the briefest of moments.